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About this podcast

How will economic sanctions against Russia and scarce commodity supply impact the global recovery? In this episode, Chief Economist Eric Lascelles looks at the outlook for different regions – including a positive outlook for the United States. He also monitors central bank activities in response to rising inflation and commodity prices. [22 minutes, 18 seconds] (Recorded March 4, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson. A lot of stuff going on right now, and when things are as uncertain as they are on so many fronts, there's only one person I call to talk to, and that's Canada's hardest working economist, Eric Lascelles. Eric, welcome.

The Ghostbusters line was busy, was it? Anyway, it’s nice to see you. Thanks for having me. That's not usually a fair assessment of how hard I work, but I would say the last week, that is a fair assessment. There's a lot going on.

I can only imagine because I'm in the same boat as I'm getting calls from people getting really nervous about what's going on, not just from an investment perspective, but thoughts around where this could go in so many different ways. I think I've said a couple of times in this podcast, growing up as a Cold War kid, sometimes I went to bed nervous because you're worried that some missile might come flying over the North Pole and strike us at home here in Canada. And one of the nice things about being a parent for the first seventeen and fifteen years of my daughter's lives, they haven't had to worry about that. And then this last week, they've asked me about what could happen out of this. It's not surprising that people are nervous. And of course, as I'm saying that, I don't want to exaggerate in any way the potential for what could happen out of this. And that's why we check in with experts like Eric. The Russian invasion of Ukraine, at a scale that I think has taken most people aback in terms of what they thought would happen; that Russia would go in, but not at this scale. What are your thoughts as you watch the first week of this invasion play out and then how markets and the global economy has reacted?

With the caveat that I'm not a military strategist per se, though I do like to play one on your podcast every once in a while. You're right, this has been towards the most negative end of the spectrum. It wasn't certain that Russia would attack. They would have gained certain things just by threatening, and Putin's domestic popularity was already rising, and things like that. So it wasn't guaranteed they would attack. If there was an attack, it was much more likely they would restrict themselves to Eastern Ukraine areas they've already laid claim to, but this does appear to be a complete country invasion, and to the extent it is proven initially challenging for the Russians, it has escalated in a real bombing campaign now. So it's an enormous tragedy, and it's not clear what the end game is. You do have to assume that Russia does lay claim to Ukraine and has sufficient military force to do that, but holding a country is a whole lot harder than claiming it initially. And so it could be a very messy affair for Russia for the foreseeable future. Thereafter, open question: the extent to which Russia has aspirations to recreate the historical Russian Empire or the Soviet Union, and thoughts about other countries, though I think the fact that their mouth is pretty full with Ukraine suggests that's probably not in the immediate offering, but it's not a good outcome. And from an economic perspective, certainly there's a great deal of damage that emerges from that. People don't do this, but you should start with Ukraine, obviously. The Ukrainian economy is completely devastated. Usually, people start with Russia and work out from there, but the Ukrainian economy is destroyed for the moment, with very serious and long-lasting infrastructure damage. Really, are many people heading into the office environment like this? Clearly not. And people— men, I suppose— pulled away towards fighting and a lot of refugees— a million plus, I think at this point in time. So it's truly awful for the Ukrainian economy. That is the most negative hit. It is quite bad for the Russian economy to the extent that the West has responded with aggressive sanctions and has been ratcheting those higher. And by the way, one of the concerns one has to have is that escalation seems to be happening steadily here, both on the military side and the sanctions side. Where it stops, no one quite knows, but as it stands right now, it's quite bad for the Russian economy. I don't have exact numbers in my head, but you got to think certainly it's a recession for Russia. It's probably quite a deep recession, whether it's 3% off GDP or 20% off GDP, I don't think we quite know at this juncture, but it's a real heavy hit to the Russian economy. And then for the rest of the world, big consequences too, not on that same scale, obviously. Mostly through commodities; commodity prices and their availability. Russia's economy is only 1.7% of the global economy, so not huge by itself, but it produces 10% of the world's oil, 20% of the world's natural gas, a lot of wheat, a lot of potash, a lot of aluminum, these sorts of things. There are consequences to those markets. We have seen now commodity prices significantly adjust. I think it's probably not unreasonable to think there could be some further adjustment. Our base case scenarios do imagine that. But there are worst case scenarios as well in terms of a significant chunk of that oil or gas production going offline, and we could be talking even significantly higher energy prices. That last thing isn't quite the base case, and it seems contrary to Russia's interest to unilaterally shut off that export. It's the only source of foreign currency right now, and certainly counter to Europe's interest to shut off its use of that natural gas in particular. But there are worst case scenarios involving that. For the moment, though, if we assume that there is some diminishment of these key commodities but not a complete cessation, it does take about three quarters of a percentage point off European growth. Not quite a recessionary hit, but a pretty big hit. It's notably less for North America. It might be a third of a percentage point off US growth; it might be a quarter of a percentage point off Canadian growth. Canada gets hit less, by the way, because it produces a lot of those very same commodities that Russia produces. We make oil, we make wheat. Not to say the country benefits outright, but aspects of the country actually benefit from the higher prices. And at a minimum, we can serve ourselves significantly. So there's less damage there. Asia gets hit a bit more to the extent that it is very energy import reliant. Latin America, less. Latin America's commodity is rich as well. A few considerations like that. But as it stands right now, serious economic hits that we've now factored into our forecasts, and it's still an economic recovery year, we think for 2022. No shortage of challenges stacked up in terms of central bank tightening and high inflation, and now this. I won't claim it's a perfect situation, but believe it or not, when we crunch the numbers on those things, we do still have an economic recovery; a decelerating economic recovery is the key message there. We're now looking at growth numbers in the realm of 3% figures for a lot of these developed countries, which is still wonderful by pre-pandemic standards, but not the 4% that the market was expecting as of a couple of months ago, not the 6% that were achieved over the last year. It's certainly quite a bit less, and a bit less margin for error. And then lastly, on the market side, clearly they have suffered to some extent, Russian more than the rest, but we've seen some decline and some risk aversion. And of course, that's not unreasonable to the extent we have this new source of uncertainty, and we do have a somewhat diminished growth trajectory. But equally, we are being somewhat optimistic and looking to take advantage of cheaper markets where that cheapness doesn't seem completely appropriate. And as I'm sure you've discussed perhaps in the past, with all of our friends listening, historically, geopolitical events bottom surprisingly quickly. You're usually talking a matter of days to weeks before the market bottom is hit, and frequently it's a matter of weeks to months before you're back to where you were beforehand. We do need to keep that in mind. This is a bigger conflict than many that we've dealt with in the past, but not bigger than all of them, I don't think. Again, a lot of uncertainty, in particular on the commodity price side. That's where I'm still working hard to sort out all of the implications. If countries stopped buying Russian oil, would other countries start buying more? It's trading at a discount. It can't be quite so simple as saying that if Canada and the US stopped buying— and Canada is stopping, but it's a pretty nominal purchaser of Russian oil—that therefore much oil has been removed from the global stage. It probably winds up in India or China or a place like that. So, it's complicated stuff. But again, I think it's reasonable to think— this is true outside of geopolitical events— that when markets go down, you should be becoming enthusiastic about that as opposed to becoming more pessimistic. That's a winning strategy such a large fraction of the time.

I just want to jump in— and you commented on it a little bit—, but it's important to say that our role here and our job every day is to be analytical, to look out across the world and understand from an economic and market perspective what's happening in the midst of any crisis, natural disaster, military conflict, etc. It could be any tragedy happening around the world. But we're human; we have lots of friends of Ukrainian descent, coworkers, people listening. Like everyone else, we’re praying, supporting any way we can the Ukrainian people in this struggle, because it is a very challenging situation. Ukraine, you mentioned, is somewhat lost in the focus on oil, but it has sunflowers, a huge wheat producer, it has aluminum. And this is an economy that is pretty much going to go offline altogether for a while.

That's right. We do need to keep Ukrainian in our hearts, as you say, but also in terms of its own ramifications economically. It's a big commodity producer as well. And those commodities in particular will take quite some time to fully normalize, to the extent that production is just not coming back quickly. So, yes, this is an issue that's going to be with us for a while. And I should mention, Dave, at the risk of overstaying my welcome here, that long-term implications are awfully important too. Here we are, clearly in a cold war again. You could argue there's been a cool war for a while between China and the West, so maybe it's not quite as brand new as we're pretending, but nevertheless it's a real thing. And historically, when that happens, you end up with cliques of countries that don't quite see eye to eye, with multinational institutions becoming more feeble, and with global trade not quite working as well. So there's a subtle but long-term drag that emerges from that. NATO, emboldened, found its purpose again. Military spending is set to rise, Germany above all, but a lot of NATO countries doing that. More interest in joining NATO; more interest in joining the EU. The Ukraine has requested. I believe Georgia just requested in the last few days— probably not a fully realistic aspiration—, but still countries picking sides as cliques forming. I think that's an important one. Fiscal deficits, probably a little bigger to the extent that military spending itself is bigger. That's worth considering. Maybe— I hope not— but more nuclear proliferation. Belarus talking about getting nuclear weapons back, and certainly any country out there is observing that Russia gets to do a lot of things in significant part because of the threat of nuclear weapons. And Ukraine didn't have much of a chance, in part because it didn't have nuclear weapons. Japan, I think, even musing about allowing US nuclear weapons onshore for the first time, and so potentially some nuclear weapon proliferation, unfortunately. And energy is the other thought. Clearly the energy pinch is most extreme for Europe, which is quite reliant on Russia for natural gas and oil. About 40% of European natural gas comes from Russia. We've already seen changes as Nord Stream’s two pipeline canceled effectively by Germany just as it was about to become operational. But in the short run, it's a scramble for other energy sources. So, we’ll likely see Germany keep the nuclear going for longer and reactivate the coal. And I'm afraid to say, many of the green initiatives being pushed by President Biden in the US are probably not a priority right now. The goal is to get that price of a gallon of gasoline down. And unfortunately, that takes a backseat as well. Over the long run, maybe not, though, in the sense that Europe very much wants to be energy independent. That vision is via green energy and there’s nothing like a bout of high energy prices to improve fuel efficiency and get green technologies going. So, there could be a long-term win for green energy, but it's probably a short term hit in the meantime.

Looking at Europe again, going beyond just the price of oil, and really where we see it most, the visual sign as we're here in Canada, is driving by the gas station and seeing the price go from about $0.90 a liter where I am, a year ago, to a $1.70 today, maybe a $1.80— I haven't been out this morning. If you look at energy, I believe in Europe, they price natural gas in BTUs or megatons of BCUs, and that price has gone from $18 to $200 a unit over there. Some massive increases in the cost of energy. And that just ripples through economies because as we know, as I explained to the kids— they're starting to take economics and to think about some of these issues in school—, energy ripples through everything. Anything you touch, you pick up, you turn on a light, that's energy, and it's so critical. So, Eric, let's leave that. We'll certainly be coming back to it. As you say, this is something that's going to persist. Let's go quickly, though, just to finish off on a couple of other news items. We have you on Friday each month for the US jobs report, because that has been a key measure of the recovery out of the pandemic lockdowns and different constraints along the way. Pretty good number this morning, right?

It sure was. 678,000 jobs. That's a good-looking number. It's well above the prior month, which was surprisingly decent itself. This is February date, but recall January. Of course, we thought there was some Omicron damage lurking in there, and particularly in the US, it's been hard to find. It looks like the US economy is moving quite nicely. The unemployment rate is back below 4%, at 3.8%, and hourly earnings running at 5%, which would be strong by any measure other than when inflation is running at 7.5%, of course. So some real wage losses there, but still some strength, quite strong and concentrated in leisure and hospitality. Still very much a recovery story, as the US has far fewer restrictions, but still some; maybe just risk aversion on the part of customers has ebbed. So, I would say the economic set up has been pretty good for the start of 2022. We've been pleasantly surprised by the momentum and the rate of growth. The twist is, here we are now dealing with an altered energy price landscape and this new issue. And as well as we'll get the Fed in the US likely to raise rates shortly, and so some headwinds come after that. So we probably don't get to quite sustain this remarkable rate forever. But it's certainly helpful to be moving this quickly going into that messiness.

You'd rather come into something like this with a healthy recovering economy than with a weak economy. And that strength in the economy and the focus, pre-Russian invasion, was on the existing inflation and starting to move interest rates higher. The Fed is up later this month with their decision. The Bank of Canada raised interest rates earlier this week. Your thoughts on both central banks and what they're up to? Does any of this change the path that we've embarked on and are likely to go now?

Central banks have pretty similar motivations right now. They're noting that economies are looking quite normal and, case in point, that 3.8% US unemployment rate is pretty close to where it was before the pandemic. Economic strength has been one motivator. The big one, of course, is high inflation; 7.5% in the US, and north of 5% in Canada. And arguably— I didn't get to this earlier—, it’s set to rise a fair chunk more, unfortunately, on the back of all these commodity prices. We're going to see higher numbers yet, at least in the short term. So that's the motivation. One interesting debate was, okay, this conflict came along, it spiked inflation, it hurt growth a bit, how do central banks untangle that? Do they raise rates more? Do they raise rates less? You could argue they should go more, to the extent inflation has been their real concern and inflation goes higher. They're not, though. They're going a little more slowly. They're saying growth is set to be a bit weaker. Markets have suffered a little bit. Uncertainty is high. They're proceeding a bit more slowly. And so that still entails rate hikes, as for the Bank of Canada. But at one point not that long ago, tongues were wagging about 50 basis point rate hikes to start off this tightening cycle; the urgency to get going. And Bank of Canada didn't do that. The Fed probably won't do that at this point in time. A little bit of steam has been taken out of what central banks are expected to do. They're still set to raise rates. It's still very much an inflation-focused expedition. But whereas you had market expectation at one point that was approaching seven rate hikes in the US— or six and a half— that's now been ratcheted back to some extent, and we're pretty comfortable saying we think maybe the Fed hikes rates four times or something like that. It could well be they start pretty risky, they go 25 basis points for the next few months, and then they say, oh, the economy is slowing, which we think is a healthy thing, but which we think will happen. Inflation is coming down, supply chain problems are becoming a bit less intense. And by the way, we do see evidence of that already happening. So they might say, well, the urgency is diminished. We're pivoting to quantitative tightening as bond sales happen. It's not necessarily the case that we have to have a policy rate that's two percentage points higher a year from now. The tightening is happening with consequences certainly for people with mortgages and everything else, but it's still a structurally low interest rate environment. So don't lose sight of that. Peak policy rate is probably not that far from something like 2% a couple of years out. And actually, one slightly ominous thing is, if you look at what the market's pricing now, it actually started to price in a little bit of rate cuts towards the end of 2022 and into 2023. Hard to say what happens two years from now, truthfully, but it's a sign that all this rate hiking and economy that's maturing quickly and so on. Could we be in a position two years from now when the economy is then running out of steam. And we said before, we think it will be a shorter cycle and so we don't need to pay too much attention to that quite yet, but it's something to start thinking about over the next year about how this could be a shorter cycle.

And that's one of the key points to come out of it. From an investment perspective, knowing where we are in the economic cycle is an important factor in the positioning of your portfolio. Eric does some fantastic work on the business cycle and that's something that you can source out in market. The other couple of things I just wanted to highlight, because I think it's really important, you touched on a couple of points that provide some real perspective. The first is economic growth. We have 3% economic growth in Canada this year. So that's down from even your forecast, which again we've talked about. It prescient that you thought the potential for growth to not be as strong in Canada as some other forecasts out there. But when we look at the incredible economic expansion we had in terms of length from 2010 to 2020, growth rates were well below that, typically, on an annual basis. So we're still looking at very healthy growth. And we would say that across, as you said, all developed markets. And then as well, we're sitting at about 175 basis points right now on ten-year bond yields. We may not see the same level of increases from central banks as might have been expected even three or four weeks ago. And then even with all of that, even with these increases, rates are historically low. So we're not moving from 5% to 10%. We're moving from a virtual 0% rate, because of the circumstances around Covid, to a rate that is still very low and allows lots of lubrication in the economy. And then economies like China are actually doing things to stimulate their economy now. Again, I don't know how you keep up with it all, Eric, but it's great to catch up with you today.

Likewise. Thanks so much for having me.

Disclosure

Recorded: Mar 7, 2022

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